Good day, ladies and gentlemen, and welcome to the second quarter 2019 earnings call. (Operator Instructions) As a reminder, today's conference is being recorded. I would now like to turn the call over to Patricia Ackerman, Senior Vice President, Investor Relations, Corporate Responsibility and Sustainability and Treasurer. Ma'am, you may begin.

Good morning, ladies and gentlemen, and thank you for joining us on our second quarter 2019 results conference call. With me participating in the call are Kevin Wheeler, Chief Executive Officer; and Chuck Lauber, Chief Financial Officer.

Before we begin with Kevin's remarks, I would like to remind you that some of the comments that will be made during this conference call, including answers to your questions, will constitute forward-looking statements. These forward-looking statements are subject to risks that could cause actual results to be materially different. Those risks include, among others, matters that we have described in this morning's press release.

(Operator Instructions) I will now turn the call over to Kevin who will begin our prepared remarks on Slide 3.

Thank you, Pat, and good morning, ladies and gentlemen. Chuck will elaborate on our financial performance in a moment, and while China continues to be particularly challenging, I am pleased to highlight several items and actions which help position us for future success.

Number one, our solid operating margin performance in North America remained steady despite expected lower water heater volumes compared with last year. We announced a price increase of up to 4% on our North America wholesale water heater portfolio effective August 1 -- excuse me, this August -- early August. We joined our Hague and Water-Right water quality dealer sales organization together so as to represent one customer-facing -- our customers in that channel, and the transition has gone well. Continuing our strategy to leverage our distribution channel, we launched our A.O. Smith-branded water treatment portfolio in the U.S. wholesale channel. We revised our China sales expectations as we moved into the back half of the year, with a path towards more normalized channel inventory levels, which as previously discussed, has been elevated for over the past 15 months.

Chuck will now describe our results in more detail, beginning on Slide 4.

Thank you, Kevin. Sales for the second quarter of $765 million were 8% lower than the same quarter of 2018. Earnings in the second quarter of $102 million declined 11% from the second quarter of 2018, and second quarter earnings per share declined 8% to $0.61.

Sales in our North America segment of $524 million declined 2% compared with the second quarter of 2018. Lower residential water heater volumes due to a tough second quarter 2018 comparison, driven by a pre-buy in advance of the price increase were partially mid -- offset by the mid-2018 pricing actions.

In addition, our recently acquired Water-Right business added approximately $14 million to sales. Rest of the World sales of $249 million declined 19% compared with the same quarter of 2018. China sales were down 16% in local currency primarily related to previously disclosed channel inventory build, which occurred in the first half of 2018 and did not repeat in 2019.

The weaker Chinese currency unfavorably impacted translated sales by approximately $16 million. India sales grew over 30% in constant currency compared with the same period in 2018.

On Slide 6, North America segment earnings of $123 million were 2% lower than segment earnings in the same quarter in 2018. The favorable impact from mid-2018 pricing actions were more than offset by the unfavorable impact of lower water heater volumes and higher steel costs and other costs. As a result, second quarter 2019 segment margin of 23.5% was essentially the same as last year.

Rest of the World earnings of $22 million declined 35% compared with the second quarter of 2018. The impact to profits from lower sales -- lower China sales more than offset the benefit to profits from lower SG&A expenses. Weaker China currency translation negatively impacted earnings by approximately $2 million.

As a result of these factors, the segment margin declined to 9% compared with 11.3% in the same quarter of 2018. Our corporate expenses of $9.6 million were lower in the quarter compared with the second quarter last year, primarily due to lower incentive-based compensation.

Interest costs were higher in the second quarter than a year ago due to the acquisition of Water-Right in early April. For the year, we expect interest expense to be approximately $11 million. Cash provided by operations of $144 million during the first half of 2019 was lower than $173 million in the same period of 2018. Lower earnings and higher working capital investment resulted in lower cash flow from operations. Our liquidity and balance sheet remain strong. Our debt-to-capital ratio was 17% at the end of the second quarter.

We have cash balances totaling $578 million located offshore, and our net cash position was $219 million at the end of June. During the first half of 2019, we repurchased approximately 2.8 million shares of common stock for a total of $133 million. Through yesterday, we purchased approximately 4 million shares at a cost of approximately $185 million, accelerating the pace of our repurchase due to valuation.

Approximately, 6.3 million shares remained on our existing repurchase authority at the end of June. We continue to see prolonged headwinds in the appliance market in China. And recent indications from our customers in China inform us that they will reduce orders for the third quarter. As a result, we have revised our 2019 EPS guidance to a range of between $2.35 and $2.41 per share, a 9% decline at the midpoint compared to last year.

We expect our cash flow from operations in 2019 to be approximately $400 million compared with $450 million in 2018 primarily due to lower earnings. Our 2019 capital spending plans are approximately $85 million, and our depreciation and amortization expense is expected to be approximately $75 million in 2019.

Our corporate and other expenses are expected to be approximately $49 million in 2019, slightly higher than last year due to inflation. Our expected effective tax rate is expected to be approximately 22%. We expect to repurchase our shares in the amount of $300 million in 2019. We expect our diluted outstanding shares in 2019 will be approximately 107 -- 167 million. I will now turn the call back to Kevin who will summarize our guidance and business assumptions for 2019, beginning on Slide 10. Kevin?

Okay. Great. Thank you, Chuck. Our outlook for 2019 includes the following assumptions: we project U.S. residential water heater industry volumes will be down 50,000 to 100,000 units in 2019 as replacement remains stable, but new home construction appears to be lackluster due to labor shortages and weather delays; commercial industry water heater volumes are expected to be up 1%; based on boiler sales growth of 7% in the first half, we expect our North America boiler sales to grow approximately 7% for the full year; we project India water heater EBIT will be positive in 2019 and improvements to continue for water treatment in 2019, and that overall in India, we will be profitable in 2020; our forecast for the Chinese currency in 2019 is essentially level with where it is today and weaker than last year. Essentially, all of the negative FX impact occurred in the first half of 2019. We see continued and prolonged headwinds in the appliance channel in China.

Our third-party analysis of overall market performance in the second quarter showed the electric water heater market was down 8% to 9%, gas tankless water heaters down 2% to 3% and water treatment systems down 1% to 2%.

As previously discussed, we estimated 2018 China sales increased due to distributor inventory build primarily in the first half of 2018. We are assuming continued weakness in the China consumer demand for the full year in 2019. We continue to improve our process to quantify inventories. While we experience seasonality, a normal inventory level would be 2 to 3 months. Our current view is that the channel inventory is approximately 4 months.

Based on our recent conversations with key customers, we expect channel inventory levels to decline over the back half of the year to approach normal channel inventory levels by the end of 2019.

Due to the 2018 channel inventory build and with the impact of the expected 2019 channel inventory decline, we are projecting full year sales to be down approximately 16% to 17% in local currency terms. Combined with our expected 3 points of unfavorable currency translation, our 2019 sales projection is a decline of approximately 19% to 20%.

We expect third quarter 2019 channel -- China sales to be down 20% compared to the third quarter 2018. Due to the decline in sales, we expect client inefficiencies, reductions in headcount and higher mix of mid-priced products will have a slightly lower contribution margin -- will weigh on margins.

We forecast China third quarter 2019 operating margin will essentially break even. We expect fourth quarter performance to be similar to the second quarter as the fourth quarter is typically the strongest quarter of the year, offset by expected continued channel inventory declines.

Please advance to Slide 11. We continued -- we see continued momentum in North America with our water heater, boiler and water treatment products, collectively expected to grow up to 6% in 2019, including approximately $40 million in Water-Right sales. Our profitability improvements and sales growth in India is also encouraging. Our business model in China is solid, and we are committed to the region for the long term. We have near-term challenges to navigate through in China as the economy remains weak. We continue to stay close to our distribution customers as they work down channel inventory, and we continue to review our cost structure to rightsize the business.

We project revenue will decline by 2% to 2.5% for the year in U.S. dollars and 1% to 1.5% in local currency. EPS is projected to be between $2.35 and $2.41. We expect North America segment margins to be between 23.5% and 23.75% and Rest of World segment margins to be approximately 6%.

Our stable replacement markets, which we believe represent approximately 85% of North America water heater and boiler volumes, and the long-term growth drivers in water treatment solutions and boilers across North America and favorable demographics in China and India coupled with our strong balance sheet, position us well to enhance shareholder value. That concludes our prepared remarks, and we are now available for your questions.

So we -- we've been -- typically, we don't talk about price. I would say historically, we've been able to offset increased costs with pricing actions. Our assumption -- I'll tell you that our forecast and assumption on steel is that currently, we forecast that it'll be like -- it'll be this level for the rest of the year. And we have seen recently, this last month, some increases in steel prices -- or some indication steel prices may be going up.

Okay. And then I believe you're previously done with head count reductions in China, but given the lower outlook, would you reduce this more? Or do you believe you have already rightsized the business for current market conditions?

No. We're going to continue to review the business, as we always have, and we'll be aggressive. The first headcount reduction was about 10%. We completed that in the first quarter of this last year. We are planning an additional 5% reduction in Q3. And then the SG&A that we continue to look at and scrutinize to make sure that we're spending our money appropriately there and investing appropriately, and we're going to continue to close unproductive stores. And so at the end, as we look at it, as the market was to -- and continues to evolve, we'll aggressively adjust our business and we will rightsize the business to the current environment.

I wanted to start with Rest of World and maybe if you could try to characterize for us the visibility that you see? I know you mentioned that you believe that the inventories may be normalized towards the end of the year. But given the big step change from last quarter to this quarter, maybe if you could just talk about visibility and what you can see going forward? And in terms of the numbers you highlighted about the volume declines, has that stabilized or has that -- in your view or do you -- or has that not found a bottom in terms of year-on-year declines?

This is Chuck. Let me just talk a little bit about China. So what we've talked about in the past is a weak economy and that continues. So we've continued to see a weak economy. That really has not changed. We've talked about elevated inventory in the channel. That has not changed. The elevated inventory remains roughly on -- where it has been, really since we started talking about it June of 2018. We've also talked about assuming a -- our outlook, last call we said assuming a flat channel inventory, we'd be down 6% to 8%. What's changed in our visibility is that recently, as we come out of June and had conversations with the customers, we've seen customers telling us that they are going to order less in the third quarter. Now typically in the third quarter, and we talked about this on last year's call, because the fourth quarter's typically our strongest call --- strongest quarter in the market, we would see inventories go up. What we're looking at now and the visibility that we see and we've scrubbed it and we think we have a clear -- we certainly have a clearer picture in the last couple of weeks is that we would expect that those inventories would start to come down in the third quarter. And by the end of the year, we'd be going out of the year, at least in our assumptions, at an inventory level roughly at what we went out of 2017 at. So really, really reversing out the inventory that went into the channel last year, and it would be flushed out. And back to what Kevin said, more normalized 2- to 3-month inventory levels by the end of this year.

And just to add on to that, you asked if we've hit the bottom, and we certainly hope so. And we're still going to sit back and make sure that what -- we're watching our business. And as I mentioned to the previous caller, if additional adjustments are needed, we'll aggressively go after those to continue to rightsize the business. But we do believe that we've given the best outlook based on all that what Chuck had said on our visibility into the inventory, and we hope this is the bottom.

Yes. So for the year, it's approximately year-over-year, $24 million to $25 million of savings within the SG&A category. Think of that in terms of the -- it's split roughly first half, back half, equally. The back half is a little bit less, and that's because we've got some investments in advertising we're going to do to -- for the fourth quarter, but that's roughly the amount. There's a little headwind on the back half because we do have some severance cost that would be associated with the headcount reductions.

So I guess the first question is thinking through kind of -- I think you've guided to flat margins in China in third quarter and then 6% for the full year. You talked about some deleverage there. Could you just walk us through kind of a bridge of where you think -- because I think your initial guide was kind of in the 11% range. Can you just bridge us, what's deleveraged, what's restructuring? What are the buckets -- sales volume that get you from, kind of the 11% to the 6% for the full year?

Yes. I mean I -- so I'll just kind of take it in the big bucket. So we've talked about the inventory coming down. That's a pretty big bucket. It's rather acute in the third quarter, so when we're thinking about the third quarter, you have to kind of look to the first quarter to find something that's comparable. It's 20% down from last year. And at that level, we've got some pretty meaningful plant inefficiencies that we were -- not had except expected before, that gets us through the third quarter. And then the fourth quarter looks quite a bit like the second quarter. So we still have some headwinds on channel inventory, but we get back to a little bit more of a normal -- not normalized, but a little bit higher volume level that runs through the plant. So when you kind of take all the buckets together, first quarter or -- I'm sorry, second quarter just gets hit fairly hard by the lower volume.

Okay. And then maybe as a follow-up. How are you thinking about, perhaps, your balance sheet right now in terms of M&A? Maybe considering -- I mean, obviously it looks like today, there's been anticipation of this cut given how your stock is traded intra-day, but nevertheless, you're in a bit of a fight of a lifetime in terms of what's going on in China and the organic growth story. If you see a material market break with your stock, do you think given the fact that you've got a balance sheet that's maybe suboptimal from a cash redeployment standpoint, you would consider being very aggressive in terms of share buyback? Because if you think about it, you might be able to get your business at a substantial discount over the next 12 months as you kind of rightsize and restructure this business. How do you think about that in this environment?

Well, I'll get back to China. The China change that we have is -- we think will work through the inventories about the end the year. Once we get through that, we would expect a bit more normalized operating performance. So we certainly have seen changes in China, and we're going to work through them by the end of the year. So thinking of our balance sheet, we're going to buy back $300 million of shares, or at least we've projected to buy back $300 million of shares this year. So we're going to continue to do that. So we're on track to repurchase more than we did last year.

I'd like to add onto that about China a little bit. Certainly, we're in a challenging environment. I wouldn't categorize it a fight of a lifetime. We have an excellent management team that's going to work our way through these challenging times, and we'll come out the other end as a stronger organization. Positively, we have some great mid-price point products that are gaining share. Our share in Q2 was higher than Q1. So there's -- and there's been no meaningful trading down. There's been really no noticeable effect to our brand. And as we look out, we still look at China as a long-term growth part of our business, wouldn't want to be any other place than China when it comes to the growth. And when you look at it, the urbanization, we still believe it has a long runway, the movement to the middle class. So yes, we have some short-term challenges here. We have the team in place. We're making the moves we believe are the right moves in the current environment, and we'll continue to do that. We know how to do that. And then as we come out the other side, the company will be stronger, we'll probably be a bit leaner, and we'll be in position to take advantage of one of the best growth markets in the world. So it's important for us to do the things we're doing. But again, I believe our management team has it under control, and we have a line of sight of what we're going to do to manage our way through this challenging environment.

Last question. Given what you see in the U.S. in terms of slightly negative organic growth and obviously, this could just be -- just timing and price increases and still -- do you still feel good about the fundamental long-term outlook for the U.S. And obviously, that could impact obviously, margins because you've got great margins there, you have for some time and that's -- I've been skeptical of it, and you've been -- you've delivered, which is great. But do you see anything on the horizon that would give you pause that the market's changing or the cycle's changing where you think that the organic growth there is going to be more challenging going forward than it has been over the past several years where you've had very, very solid, stable organic growth in North America?

Yes. The answer to your question, first, we still believe there's stable organic growth there. What's going on in our opinion and what we believe, is if you look at the market through May of residential water heaters, the shipments in the industry were down about 150,000 units. And as we look at our June sales in our sales and we look out, we think it's going to be down another 100,000 units. And as we look at it, there's certainly been an impact of a wet spring that's limited new construction. There continues to be a labor shortage with most of the builders and so forth. So as we go forward, the reason we have it declining is we just don't think with the labor shortages out there that the industry can make up the full 250,000 units. We think it's going to be somewhere in the 150,000 range. But what's important, and we said it in our opening comments, we still see a very stable replacement market. And again, as we go forward, we have no change to our North American growth pattern. Water heaters are at 4%. We believe Lochinvar will continue to grow at that 8% to 10% range. So, no. That was a long answer, but no. The answer is we feel really good about North America. We think this is just some weather-related issues and that hopefully as the labor shortages in the market start to become less that the new construction will continue to move forward. So no change in our outlook on either of our North American businesses.

We've had a prolonged slowdown in China, right? So it's been a number of quarters that we've been talking about the elevated level and the prolonged slowdown. June, typically, is a favorable month for the appliance channel. It's a high-promotion month. I think there is some disappointment perhaps in June. Maybe it wasn't as high as what expectations were in the customer base. And as we came out of June and the prolonged level of what the downturn is, I believe our customers just said, "It's time to delever a bit." So I would say those data points -- and last year, we went into Q4 with pretty high inventory levels and wanted and expected that the channel would flush those out, and it was a little disappointing. So when they start looking -- when our customers start looking back and historically, and look at the data points of last fourth quarter, June and maybe what they see in front of them, they've decided to take action right in the third quarter.

So maybe if you can flush out in Q2 then and what your expectation is for the year between the water heater business, the water treatment business and air purification in China, can you give a little bit more granularity as to actual performance in Q2 and full year expectation for those 3 buckets?

Well, let me kind of carve out water heating and water treatment. So what water treatment -- so for the quarter, water treatment was down about 12%. Largely, channel flushing -- or reduction of the channel inventory impacted. When we look at our water treatment business over the course of the year, we would expect to be down about 12% on our sales. If you look at, kind of, the consumer demand, the customer demand and what we're seeing on sellout, it's probably up about 8% to 10%. So we're seeing a little bit positive there. The water heater, you've got to kind of look at the mix, right? So we've introduced some mid-range price products. We've introduced new products. We do have headwind on the water heater side. Our outlook for the back half of the year is to be similar to the first half of the year as far as consumer demand. We see -- we saw last year, 2018, slightly downtick in consumer demand from 2017. But we've seen the first half of 2018 be fairly similar to last year, and that's what we're assuming for the rest of the year.

So just continuing on that. There's a lot of inventory machinations as well as just the timing of when you guys are manufacturing this year versus last year. Performance relative to the market in the core China product categories, how do you think that's tracked lately? And what's the assumption moving forward from here?

Knowing that the best tracking for us is market share. And so if you look at our product categories, we've -- we started the year out a couple of points down overall. But as we go forward, our market share in Q2 exceeded Q1. We're getting really good acceptance of our new products, mid-price point products in the market. So -- and as far as the premium channel, it's continuing to hold, it's down a couple of points overall, the channel, but the -- overall, it's holding. So as we go forward, we believe we're getting our fair share, and we're continuing to gain momentum on the online side of the business as with our offline. So overall, we think we're getting our fair share, and we look for a back half on a sellout perspective, not so much as sell-in because that's the inventory side of it. We feel we'll continue to get our fair share and possibly move our market share up in a couple of categories that we were down a point or so.

It includes both. It -- as we've talked, we have so many different categories, but the 3 main categories that Chuck outlined, I feel comfortable that we'll be getting our fair share in all 3 of those categories.

Can you just talk about market share, how your market share is holding in North America on the res commercial water heater side? And then just how are things progressing relative to plan within North America water treatment?

Well, let me take the North America water heater residential share question. We had a very good Q2, and our market share on all of our key categories, particularly residential and commercial, were back in line with our 2018 levels, maybe, actually slightly up. So we've -- we had a soft first quarter, and we recovered in the second quarter and we don't see any reason that's going to change. On the water treatment front, Chuck, we did a very good Q2.

Yes. And we talked on the last call that we expect to been incrementally better in Q2 versus Q1, and that is happening. So it's -- the business is performing well. For the quarter, our sales were about $37 million. $14 million of that again was Water-Right, which is integrating well as Kevin -- is on track as Kevin mentioned. So the kind of the customer acquisition and core growth is low teens for us on the rest of the business. Operating margins were high single digits for the quarter. So we're pleased with the way water treatment in North America is progressing.

Well, the mid-price point products have gone in, in various phases. It does take time to certify. And I think what we've mentioned in the past, we just don't take a product and discount it and make it a mid-price point. We will actually design the product for the right category with the right cost structure. So as you go across our residential water heating, it's continuing to do well and we're gaining share on the online side of the business. Gas tankless, we still have a bit of work to do to introduce a few new products to fill those gaps, and those will happen by the second half of the year. And our water treatment continues to do well. So overall, the acceptance has been good. But more importantly, the products have been designed for the right price points with the right cost structure so that we could maintain margins. So overall, been accepted well, and we look at introducing just a few more to balance out our product portfolio in each of those categories.

Yes. Right now, we've probably got a little heavier mix of the mid-price point as we work through the back half of the year. A lot of those products are new. As Kevin said, they're pretty well accepted. The channel -- as they work down the channel inventory, there's product that is not as new. So those price points are different. But we would expect it to normalize next year -- more normalize next year. We're always -- as we grow e-commerce and as we grow the mid-price point product, it will be slightly less margin, but we would expect it to normalize. We've got just pressure on our margins in Q3, particularly because of the lower volumes. So gross margin should be a little pressurized.

Off the top of our head, I don't have that information. I'll be more than happy to dig into it and get it for you. But there's -- it's -- what I would tell you it's going to change by product category. And so what we're going to have to -- it's a great question. We'll be sure to take a note of that and make sure that we get back to you.

I was hoping to ask about cash repatriation and maybe get a sense for how much of this currently disclosed cash number is in the U.S. and outside the U.S.? And if you repatriated any cash from China in the first half or in the quarter?

Yes, we have. We've repatriated -- we dividended out of China about $150 million for the first half of the year. So all of the cash that we mentioned is offshore, just to be clear on that. Dividended out $150 million out of China, and we repatriated about $85 million of that back to the U.S.

Just -- in the last couple of minutes we've got here, I guess there was rarely a question about raw materials price cost and you noted that raw material prices were still high or maybe up year-over-year. And obviously, spot markets have been coming down. You guys are contract buyers, I understand that part, but one would think that by now you're starting to see some leakage on the indirect component as well as maybe some supplemental spot purchases. So I guess the question is, notwithstanding, I know the mills just sent out letters asking for price increases a few weeks back, but when do we start seeing the benefit of lower steel prices coming through? Do we see some here in the third quarter? Or just -- can you help us with the timing?

Okay. Okay, that's good. And then -- well it's something we picked up in our checks was just talk of moving to kind of a national pricing model. And people are -- in distribution, I guess, now that distributors are acting more on a national scale. They're pressing for more of a national price as opposed to the disparities where I guess the Southern markets are usually at a discount to the Northern markets. How does that play out for you in terms of price realization? Do your ASPs move up or down as you kind of normalize to a national level? And how does the timing also play out?

Matt (sic) [David] pricing -- we're the only public company, okay? And so we just do not get into much detail on pricing with regards to strategy implement -- or expected implementation and those type of things. And so I just would prefer to keep that as kind of our policy. And again, what we've demonstrated over the years is being unable to, at the appropriate time, given time, to address cost and inflation issues going forward, and I'm just going to leave it at that.

Couple of follow-ups. First, can you talk about what you're doing in the wholesale channel with respect to water treatment? I know when you launched into Lowe's you threw a revenue target out there. Do have a revenue target for this wholesale initiative, if you will?

Yes. No, we haven't put out a revenue target for it. We just launched into that. We would want -- it's right in line with our channel strategy. So we're excited to have product into the wholesale market effective in May. What we will kind of talk about is because of our channel strategy, we're looking at growing water treatment year-over-year in that 10% to 15% range. So if you look at our whole portfolio of businesses, not guiding just for water -- wholesale, but we would look to grow year-over-year in that 10% to 15% range throughout kind of our -- all of our channels.

Okay. And then lastly, just with respect to Lochinvar on the boiler side of the business, can you talk about what you saw in Q2 and maybe what gives you a little bit of pause with the 7% growth target versus the 8% to 10% sort of longer-term objective you have there?

Yes. That's -- let me just start with -- that the backlog in activity in the market remains -- it remains pretty active. But what I just was talking about, the wet weather and the labor shortages on the residential side of our business -- water heater side, it's also spilling over into the boiler side and commercial side of the Lochinvar business. So the business remains solid. It's just we just don't think because of the wet weather and the labor shortages, on either our water heater or our boiler side of the business, that we'll be able to make up the complete ground in the second half of the year. So that's why we brought it down a bit to 7%. But the market's active and our quoting's active, so the overall businesses is in -- it continues to move forward in the U.S.

Thank you for joining us on our call today. We will participate in several conferences in the third quarter. We will attend the Oppenheimer Conference in Chicago on August 15; the Longbow Conference in New York on August 21; and the Davidson Conference in Chicago on September 18. Enjoy your day.